The $350-million penguin

From left, Dave Krysko, Lane Merrifield, Lance Priebe and the virtual bird that has made them rich beyond their dreams.

Sabitri Ghosh

March 26, 2017November 18, 2009

The most surreal moment of Lane Merrifield's career came on Oct. 24, 2008, when the young B.C. entrepreneur found himself standing on a stage in the middle of New York's Times Square, surrounded by hundreds of adoring children and crowds of equally enthused parents. It was three years to the day that he and two partners - Lance Priebe and Dave Krysko - had launched Club Penguin, a virtual world where millions of preteens meet, chat and play games via 2-D penguin proxies. The three men had plenty to celebrate.

Tens of thousands of young Club Penguin fans, from 23 countries, had joined the high-profile birthday party via a live Web broadcast that was beaming the Club Penguin name around the world. And along with the penguin moniker, one other name appeared, though more subtly and in much smaller print: Disney. The corporate giant had acquired the start-up the previous year, for an astonishing $350-million (U.S.), with the promise of an additional $350-million (U.S.) if Merrifield and his partners met their profit targets for 2008 and 2009. Now, Disney was putting its impressive marketing muscle behind the new acquisition, sending partygoers straight from the Times Square celebration to a Toys "R" Us across the street, where they could purchase a new line of Club Penguin merchandise.

"That day is imprinted on the memory, for sure," says Merrifield, who remains general manager of the operation. "It was one of those moments that we'll definitely look back on."

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Yet, Merrifield - a born storyteller, as his Disney associates approvingly note - keeps groping for a meta-narrative other than the easily saleable one: Small-town small business suddenly hits the jackpot, earning its nice-guy founders the interest of huge companies, a set-for-life paycheque, the chance to help others and the adulation of children and parents massed cinematically in Times Square. Even as he describes the scene in New York City, he reflexively steers the point of the story away from the self-administered pat on the back of so many business anecdotes.

"At some point, I'm going to look back and go, 'Okay, what was I measured by?' " Merrifield says. "Everyone always talks about those kind of deathbed experiences and what are you really going to care about. It's not just about, what do the numbers say and what do the metrics say, and how are our stats?"

There's no doubt the numbers are impressive: When Disney acquired Club Penguin in August, 2007 - the first (and, so far, only) time it has publicly disclosed figures - the site had 700,000 paid subscribers out of a total of 12 million registered users (non-paying users can create avatars and participate in basic interactions, such as dancing and chatting and playing games, but can't access activities like exclusive "VIP" parties). According to KZero, a market research firm specializing in virtual worlds, Club Penguin's registered users had leapt to 28 million by last summer - a huge market of curious kids who could potentially be converted into paying subscribers.

But amid all the deal-making and backslapping, Merrifield and his partners say their eyes are focused on more than the money. They're trying to ensure that Club Penguin maintains the integrity and creativity of its snowy virtual playground now that the penguin has been swallowed by a very mighty mouse.

The inspiration for the site, officially known as Disney Club Penguin, came from Priebe, a Web developer who had been working for years on flash games - Internet-based activities that don't require long and memory-clogging software downloads. Priebe had been tinkering with a virtual environment for kids, and after watching an item on Fox News about the lack of safe online communities, he became convinced he was on to something. "It was the whole MySpace thing," he says. "Everybody was paranoid, saying kids shouldn't be online. It basically made me sit down and go, 'Okay, so how do you make it so they can be safe?' "

Priebe's solution was to focus on security protocols, such as filters that screen out inappropriate words and vocabulary that might compromise a player's anonymity, which he incorporated into his virtual world. When he showed the results to Merrifield, his colleague at Kelowna, B.C.-based New Horizon Productions, the young sales and marketing executive was so excited by the game's potential that he and Priebe buttonholed their boss, Krysko, and proposed the creation of a new company in which the three men would be equal partners.

To Merrifield and Krysko, two things stood out about the Club Penguin prototype - the fact that multiple users could be simultaneously represented on the screen (the term "virtual world" may be commonplace now, but five years ago, most Web environments were single-user experiences) and the safety measures that Priebe was building into it. "I was blown away with the thoughtfulness he'd put toward that," says Merrifield.

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The partnership worked from the start, not only because the three men had a clear business vision but because they shared strong religious beliefs. Merrifield had attended a Christian college in Edmonton before moving to California to pursue a career in marketing. One of the reasons he'd joined New Horizon was his deep connection with Krysko, who, in accordance with his Christian beliefs, steadfastly committed 10 per cent of the company's profits to charity each year. Priebe also came from a Christian family and wholeheartedly supported his employer's charitable policy. The trio wanted their values to be integrated into their new business. So, when they established their roles in the partnership - Krysko would cover expenses and work on the business plan with Merrifield, while Priebe would develop the product - they also agreed to donate 10 per cent of their profits to charity. (Collectively, the partners have largely supported projects that help needy kids and families in Canada and abroad.)

Priebe spent nine months developing the nascent Club Penguin; Merrifield and Krysko perfected the business model. There would be no advertising, and no charge to access the basic site, but users who wanted to buy extras like clothes for their penguin avatars or accessories for their igloos would pay a monthly fee of $5.95, or $57.95 a year. Merrifield acknowledges their monetization scheme was inherently risky: Few companies have been able to persuade consumers to pay for online content (statistics are hard to come by, but one industry observer suggests that, typically, fewer than 5 per cent of consumers are willing to pay extra for "premium" services). But Merrifield says advertising wasn't an option they wanted to pursue. "As a parent, I'll pay five bucks for a cup of coffee. Five bucks for a month's safe environment for my kid online isn't that excessive."

Beta-testing began in September, 2005, with about 5,000 kids who frequented Priebe's flash games site. The number of users swelled to 25,000 within the month. "That was when we knew we had something," Krysko says. With the site's official launch on Oct. 24, 2005, they "started to run," he says, "and once it launched, we didn't stop running."

Soon, the momentum of the growth took over, Merrifield says, "and it wasn't, 'How are we going to make this happen?' it was, 'How are we going to keep this running? How are we going to deal with the traffic?' "

Despite relying entirely on word of mouth for its marketing, and on users' ability to arm-twist their parents for its sales, Club Penguin hit profitability within three months. The site cost "far less than a million" to build, says Merrifield - and enough parents opted to pay the yearly subscription to cover the partners' costs. As traffic grew, Merrifield handled the phone support himself, and wrote a blog apprising users of new additions to the site, most of which were directly based on participants' feedback. Priebe, meanwhile, struggled to keep the servers up.

None of the partners were workaholics by nature. But, says Merrifield, they knew they had a site with unique features, and they were determined to see how big it could become. If they could quickly establish their Club Penguin as the No. 1 choice for kids, they'd beat out competing ventures by mega-companies like Disney and Nickelodeon (both of which were expected to launch imminently). They'd also prove to themselves that it was possible to score big in business while creating a sustainable company that could "take care of its employees, take care of its customers."

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By March, 2006, after Club Penguin was featured on the wildly popular British-based flash gaming site Miniclip, the total number of users had reached nearly 1.4 million, according to comScore, an Internet research company. Six months later, more than 2.6 million children were logging on to the site in Canada and the U.S. alone, and, at almost $60 per subscriber, the company was seeing rapid revenue growth - enough to bootstrap the fast-growing operation, add staff (especially moderators and customer service personnel who could respond to the growing volume of e-mails) and upgrade equipment.

Their first office, designed for 10 people, was rapidly pressed to accommodate 35, and as soon as they moved to a new location, they outgrew it. The partners began feeling the strain. "It was terrifying," says Merrifield, "because at the end of the day, we had people who were now depending on us every day to be up, to be online, and they're kids, and they're kids like our kids - neighbours' kids, friends of our kids. The level of responsibility we all felt at that point was daunting, to say the least."

What they needed, they realized, was expertise: advice and resources that could help them meet the surging demand for Club Penguin. On the technical side, they needed programming staff and data centre expertise; on the business side, they needed insight into issues such as customer service expansion and merchandising, and help with the "overwhelming" task of finding and hiring new employees. By 2007 - when projections showed Club Penguin was about to hit annual revenues of $65-million (and profit of $35-million) - the trio began contemplating something they'd never considered before: seeking another partner. Possibly a big one.

"Finding a company that had an international infrastructure in place was a huge thing," says Merrifield. "We already had over 40 per cent of our audience coming from outside of North America. So it wasn't an issue of, 'Okay, how do we expand out,' it was way more of, 'How do we just serve the audience that's there? How do we provide the same kind of phone support in Australia that we're able to provide for kids here?' "Do we go out and start looking at real estate in all these countries to set up offices? We could've - we did, we had to. But it's not what we were passionate about doing. So for us, it was as much about finding a home where we could slot in what we were great at, and then be able to pool the resources that [the partner] had, to be able to take the next big step a lot faster."

The founders won't name the potential partners they talked to, but, in addition to Disney, most industry insiders mention AOL, Sony and NewsCorp. The head of AOL's Kids and Teens division, Malcolm Bird, appeared to corroborate the rumours of his company's interest, telling a reporter in early 2007, "Yes, we're looking at a virtual world. We've got something up our sleeves [but]there's no use going and building another Club Penguin." Any discussions were cut short, however, when AOL decimated the budget for its kids' division and a frustrated Bird left in March. Then, there was Sony, which allegedly bid $450-million to $500-million (U.S.) for Club Penguin in a series of exclusive negotiations. It had much else to offer besides money: Through its PlayStation Portable brand, Sony made video games that connected users to the Internet via WiFi, and the Club Penguin partners were keen on producing spinoff video games that could interface with the site.

Merrifield won't talk about their discussions, but does say that Disney's acceptance of Club Penguin's "non-negotiable" conditions were key to reaching an agreement: The business would be headquartered in Kelowna, where the three men had settled with their families (including school-aged children); the co-founders would maintain operating control of the company; and 10 per cent of profits would continue to go to charity.

The tithing raised eyebrows among some suitors, who "looked at us a little cross-eyed when we'd start talking about that," Merrifield says. "Ten per cent is a significant amount, especially for a company that was doing as well as we were. There were only a few of them, frankly, who encouraged it."

The question of who would run the company was never in doubt, according to Paul Yanover, the Canadian-born executive vice-president of Disney Online. He says Disney wanted the team's expertise in building virtual worlds as much as it wanted their virtual world itself. The entertainment giant was about to launch a Pirates of the Caribbean game, and was developing a fairy-filled environment built around Disney's Tinker Bell character. Club Penguin's chief attributes "make us feel really confident about associating it as a Disney-branded experience: safe, family-friendly, great story, just steeped in imagination," Yanover says.

But some outsiders wondered what life under Disney would really mean for Club Penguin. Despite Disney executives' assurances that the virtual world would remain ad-free, business writer Carleen Hawn posted a piece on GigaOm.com provocatively titled "Did Club Penguin sell up or sell out?"

Two p.m. outside the Landmark IV office building in Kelowna looks a lot like 2 a.m. outside the city's many nightclubs. A flood of 20-somethings - dressed mostly in black and chatting among themselves with the effervescence of the first-time employed - ebbs homeward at the end of their shift. Replacement personnel are already at their workstations - and they in turn will be met at 10 p.m. by another tide of 20-somethings, ensuring that the fun on Club Penguin remains safe and clean 24/7.

The company moved to this location in January, 2008, and its staff - which has more than doubled since the change of ownership, to about 300 - occupies three of the building's six floors. Customer service represents the single biggest contingent in the work force, with two-thirds of employees dedicated to policing the site and answering the 7,500 e-mails it typically receives in a day.

After the deal with Disney, Merrifield says he and his partners were impatient "to move on to chapter 2," beginning with setting up services for overseas users, and they've made this a priority. Club Penguin now has satellite support offices in England, Australia, Brazil and Argentina, as well as Portuguese-, Spanish- and French-language versions. They're also developing a translation application that will allow children chatting through preset menus to see the responses of other users in their own language.

Satellite offices, plush toys, trading cards, video games, maybe even a movie: None of this would be conceivable for the toddler-aged start-up if it hadn't become part of "the Disney family," as both parties cozily put it. Still, both parties also concur that Disney has been careful to not interfere with the Club Penguin product or its operations.

"Some people ask us, 'Hey, will we see Mickey Mouse in the dojo doing card-jitsu?' " says Yanover, citing some of Club Penguin's most recognizable games and features. "And the answer is: 'I doubt it, because he's not a penguin and he's not a little kid who's playing a penguin.' "Integration is around back-office-type things that are very important, like integrating customer care. But integration is not going to be done to the extent that we would blur the integrity or the story conceit of what makes products work."

Still, the true meaning in any story comes from the confrontation of challenges, and the second chapter of Club Penguin is still being written. "User churn" - in which more users start dipping out of a site than are dipping in - is a chronic problem for online sites, and Nielsen Online data has already registered occasional drops in monthly use (May, 2008, numbers were down 7 per cent, for instance, compared with April figures). Merrifield insists, however, that user churn doesn't pose the threat to Club Penguin that it does to many virtual worlds. "Yes, we have kids who grow up and grow out of it, and that's fine. Thankfully, we're privileged and fortunate to have kids who are wanting to get into it or exploring it for the first time."

The downward trend in users, for now, appears to have been successfully reversed: Nielsen Online data showed Club Penguin had 6.8 million unique visitors during the peak holiday season of December, 2008, and 6.1 million last February, its highest numbers yet. Even so, a Securities and Exchange Commission filing by Disney this past May revealed that the company had missed its profit targets for 2008, denying Merrifield, Priebe and Krysko an additional $175-million (U.S.).

Merrifield's voice takes on a slightly defensive edge as he discusses the unpaid earnout. "The good news is, we're seeing the growth that we wanted; in the process, though, of growing, we underestimated how long it would take to build out studios in other parts of the world. The other tough thing is, in this economy, all bets are off."

Then there's the question of "ad creep": Some parents and online commentators have pointed to the ads for plush toys and video games on Club Penguin's gateway site as a sign that the partners have succumbed to consumerism. Merrifield defends the practice, saying the use of ads remains restricted to venues outside of the virtual.

But in the end, the partners maintain that the site won't change as a result of the Disney deal - and neither will their lives. Krysko has added a swimming pool to his house, and Merrifield has bought a nicer car, but all three say the money they've earned hasn't altered who they are. "I don't even think the people at my local Starbucks where I go every day know who I am, or even care," says Merrifield, whose own children still don't realize their father is a multimillionaire or that he runs the site to which so many of their peers have devoted a significant chunk of their young lives.

Krysko puts it another way: "Our values have remained the same," he says. "A good example is, we used to be able to support a child in Ethiopia or Kenya."

"We had 10 kids at one point," adds Merrifield.

"And now each of us can adopt villages. So it's the same values. It's just on another scale."

***

Trying to learn how to dance with a huge suitor who has scads of cash?

In the midst of time-consuming negotiations with a sophisticated buyer, you need to keep your company running smoothly while you angle to get fair value for your business. Here's how:

-Understand the buyer's strategic intentions: If a large firm is on a campaign to hoover up a series of smaller rivals, make sure you aren't last in the queue - you'll be crushed before realizing any value. In some cases, such as the Club Penguin deal, the buyer may want existing management to stay on. But the entrepreneur has to decide whether he or she can make the difficult transition from fleet-footed boss in his own shop to division head in a large bureaucracy. "There's an old expression: You can be rich or you can be king, but you can't be both," says Becky Reuber, a professor of entrepreneurship at the University of Toronto's Rotman School of Management.

-Weigh the structure of the payout: Cash is ideal, says Robert Orr, of PricewaterhouseCoopers. But some buyers may also offer stock or an earnout, meaning part of the payment is delivered up front and the balance is paid out if the acquired company hits certain targets. These decisions hinge on the scope of the owner-operator's new role and where the control lies. Orr says that vendors "have to make sure they have the ability to influence the direction of the company to make those milestones."

-Control the flow of information during the due diligence process: Non-disclosure agreements are standard during acquisitions, and some vendors may even seek non-compete or non-solicit clauses. But Neil Sheehy, a securities lawyer at Goodmans LLP, points out that no business can prevent buyers from learning strategic details as they kick the tires. He recommends a two-stage release: Following the submission of a letter of intent, provide corporate information, organizational structure, trademarks, some financial data, and anything that could be unearthed with routine corporate searches. After the formal offer to buy, release specific sales data, pricing, recipes, manufacturing process details. Some businesses don't disclose their ultra-sensitive information (such as names of major customers) until closing day. - John Lorinc

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